'Socially Responsible Investing':  Understanding Future Trends (2024)

Here at High Dividend Opportunities, we embrace immediate income investing with a value-investing flavor, seeking to generate retirement income along with the potential for capital gains. At times our Income Method may come into conflict with other methods of investing – although ESG Investing is one type of mindset that has benefited two of our recently highlighted picks, Atlantica Sustainable Infrastructure (AY) and Enviva Partners (EVA).

Today we wanted to briefly discuss this type of investing and look at some recent developments that may impact our holdings.

What's ESG investing anyway?

ESG investing (environmental, social and governance) is an outgrowth of SRI, or socially responsible investing. SRI decided it would eschew any investment that was believed to have a net negative impact on humanity. So these investors would refuse to invest in alcohol, tobacco, and often firearm companies. We recognize that some of our members and readers refuse to invest in Altria (MO) or Imperial Brands (OTCQX:IMBBY) due to their disagreements with tobacco companies. You may not realize you are falling into this group of investors partially. We have decided a long time ago that we will highlight opportunities as we see them and allow our members to make the decision if they morally object to investing in that company.

So where does ESG differ? It largely takes SRI one step further. ESG considers additional impacts on the environment and society, as well as the governance of the company.

ESG investing provides a way to invest in strategies using a disciplined evaluation of one or all of these considerations:

• Environmental themes, such as investing in companies that are responding to consumer demand for sustainable practices
• Social themes, such as investing in companies committed to a diverse and inclusive workplace
• Governance themes, such as investing in companies committed to diverse board composition, strong oversight, and shareholder friendly policies

Source: Fidelity

As an example, AY generates power through renewable sources, takes great care to not negatively impact the environment, and has an easily trackable corporate structure. This makes it a very positive company from an ESG mindset. Energy firms largely are viewed negatively for their impact on the environment from an ESG viewpoint.

ESG has reached a larger critical mass among investors. Large brokerages have ESG-only mutual funds aimed at matching the more socially-minded investor with firms that meet their mindset. Often it's viewed that you vote with your dollars, and as such ESG-minded investors are trying to better the world by prompting companies to adopt ESG-positive policies to attract those investment dollars.

Performance of ESG Funds – A point of Contention

ESG funds are promoted to have more strength due to their strict limitations. Companies with ESG policies are less likely to garner strong negative sentiment and have sustainable practices.

Recent reviews of ESG funds or ESG-tilted funds found that they largely outperformed their conventional counterparts during the beginning of this year. However, this review was looking into only 2020 Q1 or Q2 performance and not a longer-term look.

A recent study by Wayne Winegarden, an economist and senior fellow with the Pacific Research Institute. Winegarden looked at 30 ESG funds, 18 of which have a 10-year track record and the remaining 12 of which outperformed the S&P 500 over the recent past.

Only one of the 18 outperformed the S&P 500 over a five-year investment horizon, and only two beat the S&P 500 over a 10-year horizon. The results were no more encouraging for the 12 recent outperformers.

Source: Advisor Perspectives

The expectation that these more selective funds should outperform the general market and/or the matching mutual funds has not come true. Part of this issue may be their expense costs. ESG funds often have almost 1% higher fees that go directly into the portfolio manager's pocket. You're paying more to have fewer options and it's showing.

Data by YCharts

Comparing two Fidelity mutual funds Sustainability Bond Index (FNDSX) and Series Investment Grade Bonds (FSIGX) helps put this into perspective. Since its existence, the ESG bond mutual fund FNDSX has not outperformed the standard choice.

This underperformance would not be an issue for an individual investor who truly believed in this type of investing. They could readily accept lower returns to have a calmed conscience.

The issue comes when someone who oversees another person's investments puts that money into ESG investments.

As you can see above, large public funds are being poured into ESG investments. What are these public funds? Pension funds mostly. Essentially the retirement of thousands of public civil servants is being put into funds that underperform. They often don't get a say either. Pensions are operated by trustees – overseers who have a fiduciary responsibility.

In a nutshell, a fiduciary is required by law to put your best interests first. They must do so by investing your funds in the best route to get the best returns. ESG ideals are secondary considerations, and a Fiduciary put their environmental ideals before the financial returns of their clients.

A fiduciary duty is an obligation to act in the best interest of another party.

Source: US Legal

A Rule Change that Would Affect ESG Investments

This ongoing shift has caught the attention of The Department of Labor. On June 23, the DOL proposed a formal rule that would make it illegal for a fiduciary to invest in ESG funds if an equivalent conventional fund outperformed it. This also would mean a 401(k) plan couldn't default to an ESG fund if the plan holder did not select a fund to invest in. Most 401(k) plans use retirement term-funds to ensure the best returns for a projected retirement date.

How would this rule impact ESG investing? Well, for starters, 54% is the $5.6 trillion invested in ESG funds would potentially be forced to reallocate to non-ESG funds. This would benefit energy names such as XLE and hurt technology stocks (QQQ) that are often ESG favorites.

This DOL proposal is a clear shot across the bow of ESG-minded fiduciaries. They can invest with that mindset themselves, but when controlling vast sums of others' capital they must put aside their political and environmental views. Charges to remove investment dollars in coal, oil, weapons and "controversial" companies has been popular among new funds being created; however, their returns have not been stellar in the long run. As income investors, we also find ourselves seeing extreme value-investment opportunities in sectors that ESG funds purposefully avoid. However, if this proposed rule comes into full force, a wave of styling and buying is likely to occur in the largest pension funds within the United States.

This also helps us understand why some sectors have reached extremely overbought prices and others trend the opposite direction. Changing the world through one's money isn't a new idea, but fiduciaries trying to effect change with someone else's money is a risky proposition that the government is choosing to not ignore or allow to continue.

Conclusion

As income investors and retirees, we must be aware of the shifting sands of investment philosophy. If you are a pensioner with a large public pension fund, call your own administrator and see what kind of investments they have. If they're not representing your best interests, make some noise. For all of us, this massive influx of money into ESG investments can often be the reason why many less "popular" companies have struggled to keep up with the general market indexes.

It's important to be aware of what is going on around you while not letting it control how you choose to invest. The ESG S&P 500 index refuses to invest in Home Depot (HD) or Berkshire Hathaway (BRK.A)(BRK.B) due to low ESG scoring, yet Amazon (AMZN) that treats its employees poorly makes the cut. No system is perfect, but knowing what $5.6 trillion of invested dollars is doing is important.

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Rida Morwa

Rida Morwa is a former investment and commercial Banker, with over 35 years of experience. He has been advising individual and institutional clients on high-yield investment strategies since 1991.

Rida Morwa leads the investing group High Dividend Opportunities where he teams up with some of Seeking Alpha's top income investing analysts. The service focuses on sustainable income through a variety of high yield investments with a targeted safe +9% yield. Features include: model portfolio with buy/sell alerts, preferred and baby bond portfolios for more conservative investors, vibrant and active chat with access to the service’s leaders, dividend and portfolio trackers, and regular market updates. The service philosophy focuses on community, education, and the belief that nobody should invest alone. Lean More.